Open-end mutual funds that invest in alternative strategies have had a good year. According to Morningstar, investors have poured more than $28 billion into this category through Aug. 31, the highest growth level of all fund categories tracked by the research firm.
Alternative funds are attracting attention from regulators and the media, not all of it favorable. For example, regulators have been critical of some of their fees, suitability requirements and lack of liquidity.
Plus, many alternative products’ recent returns have been trailing the S&P 500 Index, though some investors and experts use such products not to keep up with the major indexes but to earn “reasonable returns” along with diversification.
Andrew Clark, manager of alternative-investment research for Lipper, has taken an in-depth look at the risk-return characteristics and diversification benefits of some products.
Clark put together a hypothetical, broadly diversified portfolio consisting of six long-only asset classes: bonds (U.S. and international); global equities; commodities and real estate (U.S. and international). He used a total of six mutual funds and ETFs to track these markets:
- iShares Dow Jones U.S. Real Estate ETF (IYR)
- Fidelity International Real Estate (FIREX)
- Barclay’s Aggregate Bond ETF (AGG)
- GSCI Commodity ETF (GSG)
- Vanguard Global Equity (VHGEX)
- T. Rowe Price International Bond (RPIBX)
He then measured a set of risk-return measures for these funds from March 2007 through September 2012: return, volatility, downside deviation, Sharpe and Sortino ratios, skewness and excess kurtosis (or peakedness in distribution).
Using Lipper’s alternative investment categories’ averages for each strategy’s proxy, he calculated the same risk-return statistics for each alternative strategy:
- Long/short equity
- Long/short bond
- Global macro
- Managed futures
Clark found that several of alternatives strategies (when used as stand-alone investments) had greater returns, less extreme risk and often better risk-adjusted returns.
The expert also created portfolios that combined long positions with several arbitrage strategies: arbitrage, global macro, long/short equity and market-neutral. He tested portfolio allocation to the alternatives of 5%, 15% and 30%.
The 30% allocation is on the high end for most advisors working with retail clients. A survey conducted by Morningstar and Barron’s last year found that 63% of responding advisors allocated 6% to 20% of clients’ assets to alternatives; only 4% allocated more than 40%.
Still, Clark’s calculations showed that a 30% allocation produced better significantly better results than a 5% allocation. “At the 5% level there is hardly any change in any of the (portfolio) metrics. At the 30% level, return, volatility, downside deviation and risk-adjusted return are better. Skewness tends to be better, while kurtosis is typically worse, especially for commodities and world equity. This better performance at the 30% level is typical of all the alternatives tested, i.e. arbitrage, global macro, market neutral, and long/short equity funds, and seems to indicate that a higher allocation to alternatives can improve the performance of a portfolio more than a lower level of investment in alternatives,” he explained.
The data build a solid case for including alternatives, says Clark, provided investors are willing to make an adequate allocation.
“When I talk to financial advisors and to other people who deal with alternatives, the number that’s often bounced around, in terms of a good alternative allocation for a risk averse to moderately risk averse investor, is somewhere between 20% and 30% to make the magic work,” he says.
Investors also need to understand that most alternatives’ defensive nature.
“What happens is that the good alternatives, meaning the ones that will give you that sort of protection, very typically don’t perform as well as the stock market in general does,” he cautions. “In fact, it can severely underperform it. So, to get that downside protection you have to be able to tolerate (and be) comfortable if the stock market made 20% last year, you may only end up making 10 or 15. You pay something for the insurance basically.”